In the perpetually
fascinating financial-markets world, it is funny how few
things really change.

Today, just like
any other day in the past few years, one of the greatest economic
debates still swirls around the inflation or deflation
question in the States. This old debate continues to rage because
the stakes are so high for everyone.

Inflation and
deflation are both far-reaching titanic forces that spread out and
greatly influence returns across all major financial markets. The
outcome of the inflation or deflation question is crucial for stock
investors, bond investors, real-estate investors, and gold
investors. Some investment classes tend to do well in inflationary
environments (gold and silver), others tend to shine in deflationary
times (cash and bonds), and still others tend not to thrive
in either extreme environment (general stocks).

As I haven’t
written about this great inflation or deflation question in any
depth since my original “Inflation
or Deflation?” essay published in late 2001, I figured it is
probably about time for an update. Amazingly quite a few folks
still write in today with comments on or questions about that old
essay! We are blessed with vastly more data today than two years
ago so the most probable outcome of this massive inflation and
deflation struggle is gradually becoming clearer.

Just like last
time, there is no way that we can constructively discuss inflation
and deflation unless we get the definitions out on the table up
front to utterly annihilate any ambiguity. For some reason great
confusion reigns today regarding the actual precise meanings of
these words. Here are the real and true definitions, according to
the massive Webster’s unabridged dictionary that keeps my desk from
flying away.

Inflation
… “A persistent, substantial rise in the general level of prices
related to an increase in the volume of money and resulting
in the loss of value of currency.”

Disinflation
… “A period or process of slowing the rate of inflation.”

Deflation
… “A fall in the general price level or a contraction of
credit and available money.”

There are two key
points in these true definitions of inflation and deflation that
every investor must understand.

First, note the
key monetary nature of inflation and deflation. Both of
these macro economy-wide forces are the result of changes in the
underlying money supply relative to the available pool of
goods and services on which to spend the money. If the money supply
grows at a substantially different rate than the US economy, the
inevitable result is inflation or deflation.

Second, inflation
and deflation are economy-wide forces affecting general price
levels. Rising or falling prices in particular narrow sectors
of the economy often have absolutely nothing to do with inflation or
deflation. Energy prices rising alone in isolation often have
nothing to do with inflation. Conversely computer equipment prices
falling alone in isolation have nothing to do with deflation.
Inflation and deflation are only relevant across
economy-wide general price levels.

Inflation is only
possible when the general level of prices increases as a
direct result of the money supply growing faster than the
underlying economy. Deflation is only possible when the general
level of prices decreases as a direct result of the economy
growing faster than the money supply. Inflation and
deflation are purely monetary phenomena ultimately leading to
changing general prices, and the root cause is always
monetary in nature.

Today’s great
inflation or deflation debate is much easier to wade through when
one has the benefit of the proper historical perspective on how
these two great forces have impacted America. Our first graph shows
the popular Consumer Price Index, the most widely accepted measure
of “inflation”, since 1925.

The CPI itself is
graphed on the left axis in blue, while the right axis shows the
annual rate of change in this CPI rendered in red. When general
price levels are rising, indicated by a positive CPI YoY change, the
red line is above the thick gray zero-CPI-growth line. Conversely
falling general price levels are noted when the CPI YoY change falls
negative.

As this long-term
strategic perspective reveals, rising general prices, inflation,
have been much more prevalent in modern American history than
deflation. For the past half-century there hasn’t even been a
hint of falling general prices, or deflation, so investors
should take this into consideration. Since inflation is the modern
historical norm, investors need to have very good reasons for
dismissing it outright and throwing in with the deflation camp.

The last time the
US witnessed real falling general prices was during the Great
Depression of the 1930s. As shown above, in the early 1930s near
the ultimate post-1929 stock-market bottom general price levels
actually fell more than 10% over one year! This environment
was truly great for savers because with each passing month the
capital they had painstakingly set aside grew more and more
valuable. Their same dollars could buy more in houses, cars, food,
and everything else we need to survive and enjoy life.

While today’s
socialist Keynesian historians who bow at the idol of Big Government
try to tell us that deflation was bad, they are dishonorably bending
history to advance their own Marxist agendas. Falling general
prices are not necessarily bad, and there is no doubt they helped
countless American families survive the Great Depression as each of
their dollars went farther and bought more of the crucial goods and
services they needed to survive. If you were out of a job and had
to feed your family, would you rather live in an environment where
each of your dollars was worth more every day (deflation) or each
was worth less every day (inflation)?

Since the early
1930s, with the minor and understandable exception of the turbulent
World War 2 years, general price levels have risen ever since. Note
above how the blue CPI line took off in the mid-1930s and has never
looked back. The 20th century could very well be remembered as the
most inflationary century in America’s short history.

It is absolutely
fascinating that almost a century of CPI data only really has two
significant slope changes, one in the early 1930s and one in the
early 1970s. Dotted white lines mark these important changes in the
rate of inflation. Not surprisingly, these incredibly important
events were the direct results of the two greatest fundamental
changes in the US monetary system of last century. Since inflation
or deflation is the direct product of the relationship of money
supplies to the underlying real economy, fundamental monetary
changes dramatically impact general price levels.

In 1933, the evil
socialist dictator Franklin Roosevelt dishonorably reneged on his
campaign promises and immediately after taking office grievously
gutted the US Constitution by banning Americans from owning gold as
well as attempting to confiscate existing privately owned American
gold. Prior to Roosevelt’s horrific thievery US citizens could
freely exchange their paper dollars for actual real gold at the US
Treasury any time they wished. Before Roosevelt, the US paper
dollars were 100% backed by gold, the US was on a Gold Standard, and
there had been zero inflation for over a century!

Before 1933 was
the Age of Gold. Back then a dollar your grandfather saved in the
early 1800s would buy the same amount of goods and services as a
dollar you saved in the early 1900s! Can you imagine living in an
environment where housing prices never skyrocketed, where grocery
prices were always constant, where transportation and energy prices
never rose, and where the value of money was as solid as the gold
that fully backed it? Compared to today’s tragic environment where
the prices of life’s necessities relentlessly rise every year and
impoverish millions, the Age of Gold was financial paradise!

Franklin Roosevelt
was without a doubt the worst president in America’s history. After
destroying the solid golden foundation of the US dollar he built the
immoral foundations of the modern Welfare State which steals
50% of the income of the productive today to subsidize the lazy and
unproductive in order to bribe them for votes. Almost all of the
huge financial and debt problems America faces today would have
never happened if Franklin Roosevelt hadn’t betrayed the very US
Constitution that he swore to protect. May history curse him and
his blighted memory forever.

After Roosevelt’s
terrible 1933 infamy, general price levels rose steadily for many
decades. Peaceful times brought low inflation and much higher
standards of living for Americans, but whenever vain politicians
sought war inflation soon jumped and the value of the US dollar
farther eroded. But Roosevelt didn’t hate his socialist foreign
buddies as much as he despised the good American people, so his 1933
gold ban only applied to American citizens.

From 1933 to 1971
foreign investors holding US dollars could freely exchange
them for gold at the US Treasury at any time. This was the Age of
Partial Gold, when the US dollar was not backed by gold internally
domestically but from a foreign perspective it sort of was. Under
the pre-1933 full Gold Standard, the US government and later the Fed
couldn’t print money unless it had the gold to back it, so the US
money supply grew very slowly and general prices remained stable.

After 1933, a
crucial component of Fed discipline was removed so the supply of US
dollars started growing significantly faster than the US economy
leading to inflation, a rise in general prices. Still though, since
foreign governments could demand real gold for their dollars at any
time, the supply of freshly printed dollars to “pay for” government
largesse and endless foreign wars was somewhat limited.

Then Vietnam came,
yet another unconstitutional foreign war waged in a far-off Third
World cesspool in which Washington had no casus belli and absolutely
no reason to spill American blood there. The combination of the
huge costs of a long foreign guerilla war and socialist dictator
Lyndon Johnson’s massive Welfare State-expansion “Great Society”
programs literally broke the bank. Together they required
unthinkably huge numbers of paper, or fiat, dollars to be printed
out of thin air to “pay” for both guns and butter. Not even nation
states can have it all!

It didn’t take
long for foreign investors and governments to recognize this
inflationary threat to their dollar holdings’ value so they started
demanding gold for their paper. At the intense rate gold was
hemorrhaging, soon the US wouldn’t have any gold left as it flew out
of the Treasury fleeing the Fed’s monstrous monetary inflation. In
1971 Richard Nixon, another absolutely horrible president who hated
the US Constitution and betrayed the American people, totally
severed the dollar’s link to gold. After his decree, not even
foreign governments could exchange their dollars for gold.

With Nixon’s final
deathblow to sound American money, the Age of Fiat Paper was born.
Now the Fed could print unlimited amounts of inherently worthless
fiat paper dollars all the time without suffering any immediate
consequences. Needless to say, since 1971 inflation and the CPI
have soared and the savings of hardworking Americans have
been stealthily stolen to fund the overpowering Welfare State. In
the graph above note the huge slope steepening of the CPI in 1971
when the international dollar gold standard was reneged.

In order to truly
understand the great inflation and deflation debate raging today,
you have to understand where we have come from in the past
century in monetary terms and where we are today. Unlike the
deflationary early 1930s, when the US was on a gold standard and
hence couldn’t print unlimited dollars, today the US has no
standards at all. The Fed can and does print (or create via
computer) as many dollars as it wants and the money supply growth
has vastly outstripped underlying real economic growth since 1971.

Zooming in to the
last four decades or so, we can really see the ill effects of the
complete severing of the dollar from gold and the resulting torrent
of promiscuous monetary growth and inflation unleashed. When
relatively more money chases after relatively fewer goods and
services, when the money supply grows faster than the underlying US
economy, inflation is the inevitable result.

Pre-1971, before
Nixon stained American history, both the CPI and broad M3 money
supply were growing relatively modestly. Interestingly, their
tracks on the graph above are even parallel, dramatically
underscoring the fundamental relationship between money supplies and
general price levels. After the 1971 severing of the international
dollar gold standard, however, both the money supplies and inflation
soared.

Of particular
interest to investors pondering today’s great inflation and
deflation debate, note the extraordinary recent growth in the money
supplies since the stock bubble collapsed in 2000. M3, the total
broad supply of US dollars, was sitting at $6t in the late 1990s and
is now approaching $9t, an unthinkable 50% increase in dollars in
circulation in only a half-dozen years or so! MZM, a narrower
money-supply measure, has also increased by more than 50% in the
same time period, rocketing from $4t up to $6t+. Yikes!

If relatively more
money chasing after relatively fewer goods and services causes
inflation, and if money supplies are currently exploding like there
is no tomorrow, and if the Fed can print unlimited dollars because
no one can officially exchange them for gold anymore, where
is the deflation threat? The more I watch this supercycle Great
Bear bust unfold, the less I am worried about deflation and the more
I fear skyrocketing inflation.

Since the end of
1998, the US Gross Domestic Product, or the total pool of available
goods and services produced in the entire US economy, has grown by
17.5%. This is impressive in light of the immense financial pain
felt in the States since 2000. But in comparison, over the same
short period M3 has rocketed up by 46.0% and MZM by 59.8%!
Money supply growth in the US, by the Fed’s own measurements, is
currently outstripping US economic growth by 2.6 to 3.4 times!
As relatively more money chases after relatively fewer goods and
services, how can general price levels do anything but rise?

Looking at the raw
data and realizing that the Fed has no gold discipline today thanks
to pathetic Constitutional traitors like Roosevelt and Nixon, it is
hard to imagine another deflationary spell today. General price
levels falling while general money supplies are soaring is virtually
impossible. For the past year or so I have been paying close
attention to who is making these deflationary arguments, and the
results of my informal observations are quite revealing.

From my
perspective, it seems like the “threat of deflation” is brought up
most often by Wall Street and the government/Fed establishment. I
am starting to suspect that these deflationary references are merely
cleverly crafted misdirections though, designed to distract
investors from the real inflationary threat. When you watch a
magician perform, he always leads your eyes to focus in one place
while the real “magic” is happening somewhere else. Alan Greenspan
himself is the master of this grand economic sleight of hand
designed to mask the true dangers of inflation.

Greenspan is
already one of the greatest inflationists in world history and he
will go down in infamy next to the notorious John Law from three
centuries ago in the history books. All the Greenspan Fed
does is print money and foment bubbles, like the late 1990s
stock-market bubbles and today’s bond-market and real-estate
speculative excesses. The problem with printing unlimited amounts
of fiat money is that price levels will have to rise as a
result.

So if you are
Greenspan and want to distract investors from the real threat, why
not pretend you are fighting the nonexistent “threat of deflation”
rather than edging towards all-out dollar hyperinflation? While
inflation has been universally recognized as a great evil and an
immoral regressive stealth tax for millennia, perhaps inflating can
be rendered acceptable if investors are duped into believing that it
is “necessary” in order to prevent the bugaboo of deflation.

If this
deflationary-sleight-of-hand-to-mask-huge-inflation hypothesis is
correct, what is the motive? I suspect the motive of Greenspan and
the pro-inflation crowd is simple. They want to flood the markets
with dollars to try and prematurely end the Great Bear bust in the
stock markets, but they don’t want the bond markets to recognize the
true monetary inflation and collapse.

A bond collapse
could send long interest rates into the stratosphere, which
would slaughter the majority of Americans with adjustable-rate
mortgages and single-handedly disembowel the refinancing boom. And
if Americans are forced by rising long rates to stop extracting
equity from their homes to buy cars and TVs, the US economy is toast
and another full-blown Depression, albeit an inflationary one, is
probably assured.

Our next graph
compares the annual change in the CPI since 1940 with the 30-year
Treasury Bond yield, or long interest rates. Naturally higher
inflation leads to higher bond yields as investors and savers sell
bonds until their yields are high enough to compensate for the
annual stealth losses in purchasing power spawned by monetary
inflation.

Long rates
generally track inflation, or more precisely inflationary
expectations, fairly closely. If bond investors expect high
inflation as in the 1970s after the Vietnam War and Great Society
Welfare State initiatives, bonds will be sold off until long rates
rise high enough to compensate the bond investors for the high risks
to their capital posed by inflation. Excess money leads to rising
general prices, and this inflation inevitably leads to higher long
rates in the debt markets.

Interestingly, in
the pre-1971 Age of Partial Gold long rates seldom exceeded 6%,
while in the subsequent Age of Fiat Paper long yields seldom fell
below 6%. If the US Fed can print unlimited dollars with no
inherent worth totally devoid of all immediate consequences and
discipline, what will stop rampant inflation? When bond
investors also start to think this way, and they will, a substantial
rise in long rates is virtually assured.

So when
bureaucratic Fed or government types like Greenspan ignore true
monetary data and constantly publicly proclaim they are “fighting
the threat of deflation”, odds are they are just stage-managing
bond-market expectations. The sleight of hand is designed to draw
the huge bond markets’ attention away from the real monetary growth
that will lead to inflation and instead refocus it on the
manufactured threat of falling general price levels. Unless someone
nukes the Fed, it is hard to imagine general prices ever really
falling in the States under this sad fiat-paper regime with which we
have been saddled by the Keynesian socialists.

The long rates
matter so much to the government and Fed because the only thing
holding back the necessary Great Bear bust in the States is the
mammoth wave of mortgage refinancings by American consumers. With
general debt levels so high, stock-market
valuations so
extreme, and the economic situation so dire, any disruption of
so-called “equity extraction”, which is really just digging deeper
into debt using houses as collateral, will lead to much lower
consumer spending in the States. Since businesses are not investing
and their excess capacity remains so high from the bubble years, if
consumers in the US substantially slow their spending a very
long recession or Depression is virtually assured.

Higher long rates,
the natural consequence of monetary inflation, are the greatest
threat to the mortgage-refi boom in the US and hence the entire
fragile basis for today’s consumer-driven US economic “recovery”.
Our final graph shows the Long Treasury rates, the 30y mortgage
rates, and the ballooning money supplies tossed in for good measure.

Mortgages,
literally Old French for “Death Pledges”, are totally
dependent on long rates established by the free bond markets. As
you can see above, the appropriately black line for mortgage debt
prices closely tracks the yields in long US Treasury Bonds. If the
bond markets suspect inflation is coming and sell off, yields will
soar higher and the mortgage refinancing game delaying the
inevitable bust in the US economy will suddenly end. Provocatively
this has already started since June!

This phenomenon is
even more of a threat today since the majority of Americans
refinancing their mortgages foolishly chose to fall into the
deadly trap of accepting hyper-risky adjustable-rate mortgages.
With mortgage rates near 45+ year lows the prudent course of action
would be to lock in fixed rates at these anomalously low levels.
But the greedy mortgage industry encouraged Americans to take on
more crushing debt at variable rates instead. So as the bond
markets sell off and long yields and hence mortgage rates soar, the
majority of Americans will see huge increases in their
monthly “death pledges”. There is nothing like debt to destroy
prosperity and lead to poverty!

As the graph above
ominously shows, between 1974 and 1981 the US M3 money supply
doubled from $1t to $2t leading to soaring long rates in the 1980s.
Similarly today the US M3 money supply has doubled from $4.5t in
1995 to almost $9.0t today, a similar span of time. Is deflation
really a threat in the coming years after a rapid 100% increase in
the US money supply much like the 1970s?

To tie this long
essay all together, the longer I contemplate the great inflation or
deflation debate and study the actual data, the less concerned I
become about deflation and the more I fear extraordinary
inflation. Deflation, a fall in general prices, is only
possible with a shrinking money and credit supply, which we
obviously certainly don’t have today.

With Alan
Greenspan, a notorious inflationist, unfortunately at the helm of
the Fed today, and with the Fed able to inflate at will sans any
restraining influence of a true full Gold Standard or even partial
international gold standard, investors really ought to be preparing
for widespread inflation, not deflation.

General prices are
certain to rise in light of recent monetary excesses. Some narrow
sectors will no doubt see generally falling prices, probably even
including real
estate, but a fall in specific-sector prices while most other
prices rise is not deflation.

For example,
computer prices were falling in the early 1980s as they are today,
but it was still a generally inflationary environment. When
rising long rates kill the residential real-estate boom and lead to
falling house prices, it won’t be deflation but just the end of a
narrow debt-financed speculative mania in houses. Even in an
inflationary environment the prices in some sectors are bound to
fall from sector-specific supply and demand factors.

As I mentioned in
my original essay
on this topic, anything typically financed by debt is likely to see
its prices plunge dramatically, like houses and cars, as the ongoing
Great Bear bust continues to destroy the gross excesses of debt via
higher long rates. Conversely, anything not typically “paid for”
with debt including groceries and general living expenses is almost
certain to rise in the coming years. We are staring down a brutal
environment of widespread inflation marked by various sectors
witnessing falling prices as debt leverage implodes.

While general
deflation was possible in the early 1930s with a Gold
Standard severely limiting monetary growth, it is all but impossible
now in the Age of Fiat Paper when central bankers can print
unlimited amounts of inherently worthless fiat currency which
inevitably leads to steep rises in general price levels.

So what’s an
investor to do?

Inflationary
environments marked by rising long rates decimate bond
portfolios and lead to horrible bear markets in equities. The US
stock markets essentially traded sideways to lower for a decade in
the 1970s until the early 1980s, the very inflationary time marked
in the graphs above. Inflationary price rises spawned by fiat
monetary excess are bad for all intangible paper assets, not a good
omen for stocks or bonds.

The ultimate
financial asset to own in times of excessive monetary growth and
hence widespread inflation is gold. Both the
Ancient Metal of
Kings itself and stocks of quality unhedged gold-mining
companies thrive in such ugly environments for the general
stock and bond markets. We have already been blessed with 30%+
actual annual realized equity returns in recent years in the
exciting
gold-stock arena, the ultimate inflation hedge. And we ain’t
seen nothin’ yet!

As these highly
inflationary trends are unlikely to abate as long as the Fed is free
to print and create unlimited fiat dollars, we will diligently
continue seeking out great investments that will thrive in these
dark monetary times for our
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newsletter
subscribers.